Uwe Reinhardt is a professor at Princeton whose son (the Marine mentioned below) served in Iraq. This piece first appeared in the Princetonian in April; I thank Willem Buiter for reproducing it on his blog.
As the Fed and the Treasury once again staff the shovel brigade behind one of Wall Street’s periodic asset-bubble parades – lest the foul economic odor in its wake seep too deeply into the rest of the economy – my mind wanders back to spring 2002, when the previous asset bubble had burst. At the end of the financial accounting course I then taught, I projected onto the screen the picture of a Princeton graduate who had just joined the Marines. “Take a good look at your classmate,” I told the 300 or so students in the class. “He is likely to be ordered abroad soon, there to lead a platoon of enlisted Marines into possibly lethal combat, for the sake of you and me, he is told. When he and his men come home – if they do come home – what will you have made of their country? Will you have used the accounting tools I taught you to make the country better and stronger, or will you have used them to engage in the shenanigans that drove our recent asset bubble and begot the current recession – just to make money, country be damned?”
America is a nation at war. Our sailors, soldiers and Marines fight with great honor at high risk to life and limb, and at very low pay, for what they believe to be our nation’s best interest. They often take added personal risks to avoid visiting collateral damage on innocent bystanders of a foreign land. Against that backdrop and the financial crisis and consequent recession now besetting our country, it is pertinent to ask: Do the leaders of our financial markets ever stop to think what their reckless recent conduct has done to the country these brave warriors fight to protect?
At their best, our financial markets play a pivotal role in enhancing human welfare. They then channel the savings of households, business firms and governments anywhere in the world efficiently to their most productive uses anywhere else in the world and allocate financial risk from those unable or unwilling to bear it to those who can tolerate it. Many of the recent innovations in these markets such as structured securities, currency- and interest-rate swaps, credit default swaps, and so on, have made these important functions ever more efficient.
But when investment banks seek profits by recklessly concocting hundreds of billions of mortgage-backed securities that are anchored in shaky mortgages whose quality no one has bothered to check, sell these dodgy derivatives to others, and even risk their own institution’s equity cushions by borrowing billions of dollars to invest in junk securities themselves, they are not making their country stronger. Instead, they act like reckless laboratory scientists who concoct toxic substances that can infect not only them, but also millions of innocent bystanders.
When investment banks sell multiple credit default swaps to buyers who do not own the underlying bond, but merely want to bet on its default, the banks stray into pure Las Vegas-style gambling. Productive risk taking is the central driver of efficient capitalism, but how does helping person A gamble on the default of a bond held by person B strengthen the American economy? Why not sell bets on the weather as well? No one seems to have a clear idea of the net financial exposure our banks have to the $45 trillion or so of notional credit-default swaps currently reported to be outstanding. In an era of widespread credit defaults, such multiple credit-insurance contracts on given bonds could confront some banks with huge claims that their equity cushions might not be able to absorb, forcing the Fed and the Treasury yet again to mobilize their shovel brigade, at taxpayers’ expense.
Finally, when, for handsome fees, smooth-talking investment bankers persuade unsophisticated treasurers of local school districts or small endowments to enter into highly risky and opaque interest-rate swaps, or into investing their limited funds in the so-called “toxic waste” tranches of complex structured securities, they are not making America stronger. They risk driving important local institutions to the brink of bankruptcy. An innate professional ethic deters the overwhelming fraction of our physicians from exploiting their patients’ clinical ignorance as no set of explicit regulations ever could. Does an analogous ethical anchor – a financial Primum Non Nocere – constrain Wall Street as well?
This is not an idle question. American leaders of finance now promise to practice self-discipline guided merely by regulatory principles rather than by explicit rules. That would be a sensible approach, but only in markets whose agents are ethically principled and, yes, patriotic – like, say, 18-year old sailors, soldiers and Marines.
Uwe E. Reinhardt is the James Madison Professor of Political Economy and a professor in the Woodrow Wilson School of Princeton University. He can be reached at firstname.lastname@example.org.